Smart Beta: Is It Better To Be Lucky Than Smart?

Smart Beta: Is It Better To Be Lucky Than Smart?

Individual investors have long been cautioned away from trading individual securities. Less than a third of professional stock traders beat benchmarked funds — those whose value follows some large-scale economic indicator. Rather than trying to pick winners and losers, individual investors have chosen to invest while assuming there will be winners. It’s still a good idea. If you don’t have time to research your investments, a whole-market index fund with low fees will provide a safe, predictable return over time.

As is always the case with investing, though, some people are prone to looking for a few dollars more. This impulse has led market professionals to tweak the traditional benchmark strategy in favor of a middle ground between actively managed investing and passive index-based investing. This new class of investment vehicles is collectively called “smart beta” investments.

Smart beta investments have received a great deal of press coverage lately after one of the founders of the strategy called their value into question. Immediate response to the news was alarmist, as tends to be the case for most stock market news. Investors retreated from smart beta investments. Should you reconsider the contents of your portfolio? Before we address the pros and cons of this investment class, let’s take a minute to understand exactly what a “smart beta” strategy is.

Smart Beta Explained

Typical ETFs follow some underlying index. For example, the Vanguard Total Market Index (VTI) tracks the performance of the entire stock market. If average prices go up, the price of the fund goes up. If average prices go down, so does the price of VTI. A manager, or a computer program, buys and sells stocks to maintain the index at this value. This is the traditional approach.

Smart beta ETFs still follow an index, but they tweak it some way in search of better returns. For example, a fund may shift its ownership of food processing companies down somewhat after peak harvest season. The fund designer expects the price of those companies to fall as the cost of their raw materials increases. Doing so may allow this fund to do better than its underlying index, and therefore provide better returns for investors.

Rules like this one may seem sensible, but not all smart beta ETFs are so simple. Many employ far more complex rules that target securities that are performing well over the short term or being actively traded at high volumes. Some critics, including strategy founder Rob Arnott, see such rules as enabling consumers to “chase” performance. This chasing leads to speculation, which has only worked so far because of the large number of smart beta ETFs following similar rules. When savvy investors realize the impact of this speculative bubble, many of these funds will be in for a rude awakening.

Smart beta ETFs are designed to increase value and transparency for investors while still keeping costs lower than comparable actively managed funds. Some do, and some don’t. Is it worth the risk?

Smart Beta ETF Risks

Many experts are concerned about the speculative bubble forming among stocks traded by a number of smart beta ETFs. They see the situation playing out like this: One particular stock is performing slightly better than its market peers in some predictive statistic, like volatility. This performance causes smart beta ETFs to purchase it. This purchase drives the price up and encourages other smart beta ETFs to buy the same stock. This circle of purchases continues to inflate the value of the stock until its value exceeds what is predicted by some fundamental statistic, like earnings. This announcement causes value investors and others to sell the stock, driving the price drastically down. These smart beta ETFs are left holding a lot of worthless paper, and their investors are losing money.

While such a scenario is far from a certainty, the possibility of a bubble bursting among this class of funds should be in the minds of investors who are considering them. Smart beta ETFs have been gaining in popularity based upon their ability to generate superior returns. Whether those returns are the result of a better strategy or merely a charging herd remains to be seen.

Whatever the future of smart beta ETFs, they are riskier investments than traditional ETFs. No matter how sound a set of trading rules seems, they could always be wrong. Being wrong, in this case, means the ETF actually underperforms its underlying index, costing earnings for investors. Examining the prospectus of any investment is a necessary step in investing. That goes double for smart beta ETFs.

Benefits of Smart Beta

When developed sensibly and employed shrewdly, smart beta rules can provide investors with better value. They can even employ balancing strategies to shield investors against risk. Income-oriented ETFs can pursue a specific yield rather than a specific price, enabling them to provide consistent, predictable returns for investors. Of course, actively managed funds can provide the same degree of specificity, but smart beta ETFs have two advantages.

These funds can provide the customizability and personalization of a managed fund while improving transparency . With an actively managed fund, investors carry some concern that the manager is buying and selling securities to benefit themselves instead of the investors. A smart beta ETF eliminates those concerns by telling investors up front what conditions will trigger buying and selling.

Because of the clear rules of a smart beta ETF, managers don’t need to invest a lot of hours. This helps keep the management costs of the ETF down, which in turn means more money for investors.

The Bottom Line

As Arnott put it, “You can use smart beta smartly or you can use smart beta dumbly.” This class of investments, like any other, boils down to individual tolerance for risk. If you can handle the possibility of loss, smart beta might be for you, but you need to carefully consider the rules involved and make sure they make sense on the ground. If you’d rather not take the risk, traditional ETFs may be a better fit.


Are Your Financial Realities Keeping Up With Your Financial Priorities

Are Your Financial Realities Keeping Up With Your Financial Priorities?

Happy New Year! It isn’t three months late, it’s just a different calendar. That’s because filing your taxes effectively closes the book on the financial year gone by while opening up a world of possibilities. Will this be the year you break free from the clutches of debt? Will you set up an emergency fund? Maybe you’ll finally start saving for retirement! New years are typically a time of reflection, and the financial new year is no exception. It’s time to kick back and dream big about what goals you’ll achieve in the financial year to come (provided you’ve finished your taxes first)!

Whatever their goals are, many Americans are about to get a big chunk of change back from the federal government in the form of a tax refund. How they choose to spend that money will be a good indicator of their financial priorities. Here, it is worth noting that there’s a big disconnect between what they say those priorities are and how they act in reality.

When surveys ask Americans what their top financial priorities are, they most commonly name managing bills, paying off debt and saving. Yet, only about half of Americans plan to save their tax refund or use it to reduce debt. Worse still, the number of Americans planning to use their tax refund in those two ways is down for the third straight year.

If you want to know what someone’s priorities are, don’t ask them. The answer you’ll get is more about what they think you want to hear than what relates to their actual priorities. If you want to know what someone prioritizes, see where they spend their money.

Do you ever get the feeling that your financial priorities might be out of whack? Since you’ve already got your receipts, account statements, credit card bills and other piles of paper that comprise your recent financial history, it’s a good time to find out. Don’t worry – this won’t be nearly as hard as filing your taxes! Try this 3-step process.


1. Establish your priorities

Going through the daily motions of life, you may never have time to think about the reasons for which you’re earning money. Very few people are getting up and punching the clock every morning with the hope of building a Scrooge McDuck-style money room. Most of us are trying to put food on the table, keep the lights on and provide for our loved ones. Those things are our priorities.

Write down on a sheet of paper the top five things you want to achieve with your money  Number one will likely be paying bills, but there’s quite a bit of flexibility in the rest of the list. Are you saving for a down payment for a house? Maybe you want to take a dream vacation or start a small business. Perhaps financing your children’s higher education is a priority for your family. You might have charities you like to support, or dreams of retiring early.

Spend some quality time thinking about where you want to spend your money. If five options feels too limiting, feel free to go beyond that. Just keep the list in order of what you want to do. There aren’t right and wrong answers here. If your priority is owning the world’s largest Barney the Friendly Dinosaur costume collection, that’s fine. What matters is that your list reflects your values and commitments.

2. Identify your realities

This is where that mountain of paper in front of you comes in handy. Take stock of your spending in any given month. For each of your financial priorities, how much of your paycheck goes to each?

Make a list of your top 10 categories of spending. Try to account for a much of your paycheck as you can. Put your biggest expenses at the top, and then list all the way down to the smallest. Feel free to make categories as you go and reshuffle them as patterns become more apparent. Don’t stress too much about where to categorize things. Just go with your gut.

Now, compare the list of expenditures to the list of priorities. Is your money going where your mouth is? Are you spending to bring yourself closer to your priorities, or do they just exist on that sheet of paper you had in step one?

3. Make a plan to fix it

Don’t get discouraged if you find you’re nowhere near your priorities. Remember the statistic in the beginning. Half of Americans are going to spend their tax refund on a big-ticket purchase or a vacation, and most of them also say they want to save for retirement and get out of debt. You’re not alone in living far away from your financial ideals.

It might not be a bad idea to revisit your priorities briefly. Perhaps you were too strict when you set your priorities. It might be that you prioritize day-to-day comfort. There’s nothing wrong with doing so, but look where it ranks on your list of priorities. Is the joy you get from your daily indulgences worth the trade-offs it brings? In short, given the plans you have, do you regret any purchases? Those are the ones you want to cut from your budget and lifestyle.

You don’t need to switch overnight from your current financial attitude to one that’s totally in line with what you want your money to do. Making too strict of a plan will make you unhappy, frustrated and more likely to bend back the other way. Don’t let perfect be the enemy of good.

Pick one action you can take tomorrow to bring yourself closer to achieving your priorities. Cancel a monthly music subscription and put the $10 into a savings account. Cook in one more time next week and put the difference toward your credit card bill. Once these changes start to feel effortless, look for more ways you can tweak your spending habits to make your priorities and realities line up a bit better.

If you need help reaching your savings goals, Great Meadow FCU can help. There are many ways you can automate your savings and assist in keeping you on the right track. Call, click or stop by Great Meadow FCU today!